Bernies Brainery Blunder

Earlier this year, We the Individuals published a piece following Bernie Sanders’ announcement to run for president. Since that time, Bernie Sanders has made a number of other proposals to “fix” this country which have been echoed by his supporters. Certain issues he has sworn to deal with are healthcare, minimum wage, and college — it is the latter which we will be addressing.

If you are a student in college, you may be aware that the costs of college have continued to rise. Because of this, students take on enormous debt which for many individuals takes years to pay off or even make a dent into. One of Bernie’s proposals is to pass a bill (College for All Act) where one of the main features is to allow for students to refinance their loans so as borrowers they can always take advantage of “favorable interest rates.” Using an argument based on “fairness” the bill states:

“It makes no sense to me that Americans can refinance their homes when interest rates are low, and that somebody can purchase a car at two percent interest rates, but millions of college graduates are stuck with interest rates of 5, 6, 7 percent sometimes for decades. That makes no sense. That is grossly unfair. This bill would cut student loan interest rates in half and lower the rate to about 2 percent for undergraduates.”

Setting aside the ambiguity of the phrase, “favorable interest rates,” this statement undermines any understanding of how financing works, or economics in general for that matter. So it is understandable that this would not make sense to Senator Sanders. But they do make sense to anyone who has even rudimentary knowledge of economics and financing.

First and foremost: why should the bank lend you money? The harsh reality is, they’re not lending you money because they care about you, or about what you’re doing with the money. They’re doing it to make money. If that is something to be opposed to then please give me $10,000, and I promise you I’ll pay you back…at some point in the future…and not a penny more.

Let’s break it down. Lenders incur a couple of costs: “risk” and “opportunity.” Consider: you’ve got $500 in the bank to last you the week until payday. Your friend blew his rent money on X (X being any vice), and needs $400 now. If you lend him the money, will you ever see it again? The possibility that you might not is what is called risk. Now instead of $500, you’ve got $100 to last you until Friday. Thursday rolls around, you’ve spent $80, and that girl you like finally agreed to go out with you tonight. So, rather than a fancy Italian dinner and a concert, you’re taking her to that Scottish restaurant, the one with the golden arches. Foregoing that $400 is what we call opportunity cost (see: economics). Sure, you might get that money back at some point, but in retrospect, it would have been better for you to have had it there and then.

Ultimately, lenders don’t care about the worthiness of the intended use of the loan. It doesn’t matter if the money is for building houses for the homeless, or just to make it rain in da club. What lenders care about is getting it back, and having the interest charged be worth the risk and opportunity cost. The only reason why lenders ask what the loan is for, is to determine the risk.

First, car loans and house loans are relatively safer loans. Safer loans than student loans. Unlike a degree (or often, failed attempt at a degree), a car has tangible, marketable value. If you don’t pay your car loan, the car can be repossessed, and the lender can at least get something back. Cars and houses are collateral, and without collateral rates are sky high. Car loans usually require insurance, so if you wreck your car, the lender gets paid. Now, if you don’t pay your student loan, the lender used to be able to garnish your wages. But if you just chose to be unemployed, the lender cannot repossess you and force you to work. They cannot physically repossess your diploma nor your education, so in what insane reality should someone be able to borrow money at 2-4% without any type of collateral? Even if they could somehow repossess it, your degree or alleged education has no tangible value. It’s worth nothing to anyone besides you.

Now, with the recent student debt protection programs, lenders can’t even garnish wages anymore so the defaulters get away for free while the taxpayers and responsible borrowers are stuck covering for them via higher interest rates.

Second, car loans are short term loans; Usually paid back within the lifetime of the car, unlike student loans, which sometimes last for decades. The shorter the term of the loan (such as for a car), the lower the risk of default, the lower the opportunity cost, and the lower the risk. If you lend someone $10,000 for 5 years, it means you’ll have to forego making other big-ticket investments in the next 5 years; like starting a business or buying a house. A loan with a term of 5 years will necessarily have a larger return because you’re not planning on starting a business or buying a house in the foreseeable future, and your savings are enough to carry you through a bad year. But 2 years is less foreseeable, and 5 years much more uncertain. You’ll want to be compensated for that uncertainty.

Finally, the interest rate is a reflection of the above factors. If the default rate for borrowers of a certain credit risk is 2%, then the lender will need to charge at least 2.04% interest just to break even (assuming they lend to all 100 debtors and not just 1 or 2). If the default rate is 13.7%, the lender will have to charge 15.9% interest to break even. Why did I use that random 13.7% default rate in the example? Because that IS the default rate on student loans from last year. If anything, with that default rate, 5%, 6%, 7% interest is LOW. It’s only made possible by government subsidies. Yes, taxpayers are paying the rest.

If it now makes sense why the interest rates are higher for student loans than for car or house loans, you’re already more qualified to lead this country than Bernie Sanders. Again, Bernie sees a problem but his solutions would make things worse. For instance, his bill proposing to “cut student loan interest rates in half and lower the rate to about 2 percent for undergraduates” is just more of the same policies but in a different sector: a glut of students, a lowering of overall educational quality as sub-optimal students who have no business attending college take up limited resources, tuition rates and prices of class supplies increasing, etc. This is basically a bubble. Combine that with the already-present federally subsidized student loans and it just gets worse. Also, like any maximum price control the consequence will be shortages — banks will be less willing to offer the same loans at lower interest rates, so there will be fewer such loans to be had.

Part of Sanders’ proposal also includes a Financial Transaction Tax; a tax levied on the sale and transfer of financial instruments including stocks, bonds, and derivatives. FTT’s are particularly harmful taxes because they are levied on intermediate factors of production rather than final goods or services. While a tax on a final good or service is inherently distortionary and inefficient, the implementation of an FTT would cause further problems.

The effects of an FTT on financial instruments are multi-faceted. The first manifests itself in an initial sell-off of financial instruments as investors drop their investments to avoid the tax. This will force the prices of the dropped instruments as the market is flooded with them.
The second effect will be a reduction in the liquidity and volume of trade. Since the tax is levied on the transfer and sale of instruments, rather than the holding of them, investors will be incentivized to conduct exchanges less as transaction costs have risen.

This leads directly to the third effect; with a decrease in the frequency of trading, the asset pricing process will take considerably more time, possibly leading to greater mismanagement of resources and malinvestment. This would also lead to an increase in volatility as prices would be more prone to extremes as the equilibrating effect of transactions would be reduced.

The fourth effect will be a drop in the price of financial instruments from the tax itself, and the cascading effect the tax will have on all financial markets and beyond. Even if the tax is only levied on so called “speculative” trading and secondary market transactions, the tax will still filter through to primary markets in the form of capitalization values and a reduced demand for financial assets.

The fifth effect, one seeping with irony, is that the FTT, in increasing the cost of capital and therefore the cost of production, will be to cause production to be lower than it otherwise would. This necessarily means that as production is retarded so too will be wages; surely not a desired outcome by self-proclaimed socialists, n’est pas?

Finally, and perhaps most importantly, an FTT would distort the cost of capital. The purpose of financial markets is to pool and coordinate savings into various lines of production allowing for firms to invest in production. An FTT would artificially increase the cost of capital which is an extremely important consideration for any firm looking to undertake a new project. The marginal impacts could be severe despite a low FTT rate due to the cascading effects. This means otherwise profitable projects, which would indicate that resources allocated to that project would be beneficial to society, would fail to be undertaken, or would be under-invested. Either way, the FTT would prove extremely detrimental.

Bernie seems to lay a degree of blame on speculation as justification for this tax but this ignores the importance of speculation. Speculation spreads useful knowledge, for one. If the speculator is any good, the speculator moves the price toward that which more accurately reflects market conditions than the current price. If the speculator is not good, they create an opportunity for others to correct it, and won’t be speculating for long. Also by doing this the speculator smooths what could otherwise be a nasty transition, if the relevant knowledge were to hit the market all at once. The speculator knows something about a particular market which impels them to buy, let’s say — which means he knows, or thinks they know and is putting his money where his mouth is, that demand has increased or will increase, or that the supply has fallen or will fall. Speculators push the price upward toward the future price which reflects the anticipated conditions, where the alternative may well be a sudden shortage. The price change impels others to begin conserving the resource and/or to produce more of it, absent which bad things can happen. Bad speculators weed themselves out quickly and create conditions that make it even more obvious (and profitable) to good speculators.

That’s the free market analysis. As it is now, we have institutional (policy-driven) distortions, and speculators acting on the knowledge derived from those policies, which drives prices toward that which the policy would tend to bring about, but which is unsustainable because it doesn’t reflect real market conditions (see the housing crisis for example which if Bernie understood then he’d know where to blame and wouldn’t be calling for such interventions).

As usual, interventions by the state in the economy will have the exact opposite effect of its stated intentions. The FTT is no different. In seeking to squeeze a free lunch out of Wall Street, Sanders and his mountebanks will be further impoverishing society.

What I find interesting about Bernie is that I do think he sees that there is a problem. For instance, the cost of college is out of control, he is correct here. However, like many politicians before him, his “solutions” would only make things worse. The problem with higher education is a real one, but as we have argued elsewhere the problem is not the lack of government intervention but a result of it.He is trying to solve the same economic ailments with the same poison that created them in the first place. More government manufactured bubbles, more more taxes, more spending. And when these bubbles burst, he is going to blame capitalism and recommend doing it all over again.The only way to reliably provide a robust and useful education to individuals is through the free market.